Your portfolio should reflect your goals.
Your portfolio should be organized and allocated in a very specific way. For example, if you are a new retiree, you may want to keep some of your assets in conservative investments to protect your capital should the market decline. Likewise, if you are still working but plan to retire in 10 years, you may be able to take more risk than a new retiree, but you still want to balance that risk with a percentage of your assets invested in short-term, high-quality bonds. But what happens to your carefully designed allocation when markets go into a sharp uptrend or downtrend? How can you maintain the allocation developed with your goals and risk tolerance?
The market is changing.
Markets could change dramatically the very day you make your investments. Even if the change happens more slowly, your allocation will eventually drift away from the decided-upon percentages. For instance, as the equity markets rally, prices of stocks you own will appreciate. For illustration purposes, say your financial plan has determined that 20% of your portfolio should consist of domestic stocks. If the U.S. stock market notches a strong uptrend, while other markets languish, your domestic stock allocation will grow beyond 20%. This could result in more risk than you originally planned.
Avoid an emotional trigger.
While holding onto a rising asset class sounds good, there is a downside. If your allocation of domestic stocks is larger than you planned, and the market goes into a nosedive, you are likely to experience a large drop in portfolio value. Not only could this make you nervous and uncomfortable, but it could threaten your ability to achieve your goals. This is where the behavioral component comes into play. Nervous investors often hit the sell button in a panic. That may lock in losses, since you are selling stocks at low prices. This makes it more difficult for your portfolio to get back to even — never mind see gains once again — once the market goes back into rally mode.
A drifting portfolio increases risk.
One way to prevent emotional decisions, while giving yourself a better chance of reaching your goals, is to rebalance your portfolio when the allocations drift measurably beyond the determined allocations. At first glance, rebalancing may seem complicated and time-consuming. In addition, it can seem counterintuitive to sell an investment that’s been trending higher, while plowing your money into laggards. But if your investment goal is retirement, you should have a very specific asset mix, tailored to your risk-and-return profile. By letting it drift too far from that profile, you may put your retirement dreams in jeopardy.
Restoring balance is not difficult.
The technical aspects of rebalancing are not difficult. Be sure you start with an allocation with pre-set percentages of large and small domestic stocks; large and small international stocks; alternatives such as real estate investment trusts or commodities; and foreign and domestic short-term, high-quality bonds. When you begin to rebalance, compare your current holdings with the predetermined percentages. If some investments have risen too far above those allocations, pare the positions and invest the proceeds into other investments that have not performed as well. It’s just a matter of doing some basic addition and subtraction to figure out where to slash positions, and where to add.
Use a calendar or percentages.
Rebalancing can be done over time, say every six months, or when your portfolio drifts significantly beyond your intended allocation. It’s neither practical nor advisable to rebalance if your assets drift a percentage point or two beyond what’s planned. A reasonable specified drift amount might be 5%. This method of rebalancing allows you to respond quickly when markets change dramatically, but be careful you don’t fall into the temptation to shuffle around holdings even if they have not gone outside the allocation windows you settled upon.
Rebalancing requires discipline.
Rebalancing, as well as sticking to your investment mix, requires discipline. There are plenty of valid reasons people skip this step, including lack of time or lack of interest and inclination. In those cases, it’s best to work with a financial planner who has a fiduciary duty and who also manages assets. This person or firm can handle the allocation and rebalancing for you, in keeping with the target allocation in your financial plan. Rebalancing may sound like a technical, even boring exercise, but it’s crucial to keep your portfolio aligned with the risk-and-return profile necessary to meet your goals.
What investors should know about rebalancing portfolios.
— Your portfolio should reflect you.
— The market is changing.
— Avoid an emotional trigger.
— A drifting portfolio increases risk.
— Restoring balance is not difficult.
— Use a calendar or percentages.
— Rebalancing requires discipline.
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7 Things You Should Know About Rebalancing originally appeared on usnews.com
